The personal blog of Adam Nash

The Best Blog Posts on Venture Capital

I’ve been thinking for a while about writing some posts explaining venture capital. While I have a lot of friends who are serial entrepreneurs and venture capitalists, one of the my realizations in the brief time I spent in the industry was how poorly understood it is by 99% of people.

Well, it looks like Marc Andreesen beat me to it. His posts contain roughly 90% of what I was going to say.

My experience with venture capital includes: being the cofounder of two VC-backed startups that later went public (Kleiner Perkins-backed Netscape and Benchmark-backed Opsware); cofounder of a third startup that hasn’t raised professional venture capital (Ning); participant as angel investor or board member or friend to dozens of entrepreneurs who have raised venture capital; and an investor (limited partner) in a significant number of venture funds, ranging from some of the best performing funds ever (1995 vintage) to some of the worst performing funds ever (1999). And all of this over a time period ranging from the recovery of the early 90’s bust to the late 90’s boom to the early 00’s bust to the late 00’s whatever you want to call it.

Normally, I’d be skeptical, but as I read his posts further, I found myself really appreciating the perceptiveness of his comments.

For example, here is a brief passage from the first post:

Within that structure, they generally operate according to the baseball model (quoting some guy):

“Out of ten swings at the bat, you get maybe seven strikeouts, two base hits, and if you are lucky, one home run. The base hits and the home runs pay for all the strikeouts.”

They don’t get seven strikeouts because they’re stupid; they get seven strikeouts because most startups fail, most startups have always failed, and most startups will always fail.

So logically their investment selection strategy has to be, and is, to require a credible potential of a 10x gain within 4 to 6 years on any individual investment — so that the winners will pay for the losers and in the timeframe that their investors expect.

All early stage venture capitalists will repeat the above analogy to you, but personally I found that in 2001-2002, very few venture capitalists internalized what that analogy really means. What it means is that you need to take a certain number of “swings” every year, just to make sure your odds of connecting with a winner pan out. In 2001-2002, too many venture capitalists sat on the sidelines, debating whether $4M should buy them 50% or 60% of a Series A company, instead of making sure that they kept investing. After all, any contrarian investor will tell you, you force yourself to put money in when times look grim.

I also really appreciated this quote from Marc’s second article:

Why we should be thankful that we live in a world in which VCs exist, even if they yell at us during board meetings, assuming they’ll fund our companies at all:

Imagine living in a world in which professional venture capital didn’t exist.

There’s no question that fewer new high-potential companies would be funded, fewer new technologies would be brought to market, and fewer medical cures would be invented.

We should not only be thankful that we live in a world in which VCs exist, we should hope that VCs succeed and flourish for decades and centuries to come, because the companies they fund can do so much good in the world — and as we have seen, a lot of the financial gains that result flow into the coffers of nonprofit institutions that themselves do huge good in the world.

Remember, professional venture capital has only existed in its modern form for about the last 40 years. In that time the world has seen its most amazing flowering of technological and medical progress, ever. That is not a coincidence.

This is what made me passionate about venture capital when I was in the industry, and it’s why I will likely return to it in some form again. There is an extremely important role to play for venture capitalists to play in getting money from large, conservative institutions effectively into the hands of risky entrepreneurs who are building the new technologies and businesses of tomorrow. You won’t get there with government funding or small business loans.

My favorite part of Marc’s series, however, is in his third article, when he discusses the current paradox of venture capital, one that has surprised me personally. The question is this:

If venture capital in the past 7-8 years has had such horrible risk-adjusted returns compared to the public markets, why hasn’t the amount invested in venture capital funds decreased dramatically?

The answer is asset allocation.

I remember my Private Equity class at Harvard, where Dave Swensen, of Yale Endowment fame, came to speak. Venture capital has become an asset class that every multi-billion-dollar institution feels like it needs in its portfolio. This is because after 25 years of modern venture capital, it because a proven fact in the 1990s that over the long term, venture capital has returned almost 2x the public market return, with low correlation to the public stock market. That may not sound like much to you, but that’s music to a money-manager’s ears.

This predictably led a significant number of institutions to shift massively into alternative investments and venture capital in the late 90’s, just in time to get hammered by the crash of 2000-2002.

Here’s the interesting part: that hammering — by people who, say, only started investing in venture funds in 1999 — has not resulted in a significant pullback on the part of institutional investors from venture capital.

Instead, venture capital has become an apparently permanent asset class of many large institutional investors — and increasingly, smaller institutional investors.

One element that I do believe Marc missed here is the behavioral finance aspect of why institutions still put billions into venture capital. You see, on average, venture capital has done poorly the last 7-8 years. But there have been some great funds that have performed spectacularly (Google, anyone?) Like hedge funds, many institutions have money managers that believe that the venture capital funds that they have picked will be the few that outperform. (Of course, most of the best venture funds turn away money regularly, but that’s another story.) Thus, everyone believes that they will be “above average”, even though that’s not possible.

In any case, definitely read Marc’s articles. Bookmark them. Read them and think about them the next time you read some press about venture capital. They are keepers. I just wish I had written them first.